Lease Financing Mini Case

Mini Case

Lewis Securities Inc. has decided to acquire a new market data and quotation system for its Richmond home office. The system receives current market prices and other information from several online data services and then either displays the information on a screen or stores it for later retrieval by the firm's brokers. The system also permits customers to call up current quotes on terminals in the lobby.

The equipment costs $1,000,000, and, if it were purchased, Lewis could obtain a term loan for the full purchase price at a 10% interest rate. Although the equipment has a 6-year useful life, it is classified as a special-purpose computer, so it falls into the MACRS 3-year class. If the system were purchased, a 4-year maintenance contract could be obtained at a cost of $20,000 per year, per year, payable at the beginning of each year. The equipment would be sold after 4 years, and the best estimate of its residual value at that time is $200,000. However, since real-time display system technology is changing rapidly, the actual residual value is uncertain.

As an alternative to the borrow-and-buy plan, the equipment manufacturer informed Lewis that Consolidated Leasing would be willing to write a 4-year guideline lease on the equipment, including maintenance, for payments of $260,000 at the beginning of each year. Lewis's marginal federal-plus-state tax rate is 40%. You have been asked to analyze the lease-versus-purchase decision, and in the process to answer the following questions:

a. (1) Who are the two parties to a lease transaction?

(2) What are the five primary types of leases, and what are their characteristics?

(3) How are leases classified for tax purposes?

(4) What effect does leasing have on a firm's balance sheet?

(5) What effect does leasing have on a firm's capital structure?

Solution Preview

(1) Who are the two parties to a lease transaction?

Ans: The two parties are the lessee, who uses the asset, and the lessor, who owns the asset.

(2) What are the five primary types of leases, and what are their characteristics?

Ans: An operating lease, sometimes called a service lease, provides for both financing and maintenance. Generally, the operating lease contract is written for a period considerably shorter than the expected life of the leased equipment, and contains a cancellation ...